The Oxford Language Dictionary definition of pro forma is "done or produced as a matter of form" or "a standard document or financial statement.” Similarly, the original Latin meaning is “for the sake of the form.” In contemporary usage, a Pro Forma is a cash flow projection for real estate investments. Pro Formas are typically forward-looking estimates of financial results. Real estate investors rely on the pro forma to analyze potential income and expenses.
By necessity, a pro forma contains assumptions, but a reliable one is carefully crafted. The essential elements of a pro forma include expense and revenue projections. Line items should consist of:
- Rental income
- Vacancy
- Concessions
- Operating expenses
- Management fees
- Real estate taxes
- Debt expense
For an accurate statement, each item should be calculated using historical data, modified by current market conditions and growth assumptions. The buyer and seller in a real estate transaction often have somewhat different numbers input into their version of the property’s pro forma. The pro forma is typically a spreadsheet and is included in the property's offering documentation.
How reliable is a pro forma?
The reliability of the pro forma document is crucial for an investor considering a purchase. Yet, the statements are based partly on estimates and assumptions about the future. For example, a pro forma includes projections about future rental income. The numbers used may reflect current rates and vacancies, with future potential being estimated optimistically. An investor should examine the current rent roll to evaluate the likelihood that future projections are achievable based on the rental market, property conditions, and other factors.
Expenses are the second major component of a pro forma and are based on current costs, including property taxes, insurance, utilities, maintenance costs, and property management charges. The data on the pro forma is based on actual current expenses but should also be validated by analyzing comparative data from other similar properties and may also be modified based on apparent trends (like pending tax increases and the age of the property), plus any deferred maintenance which could impact future expenses.
Debt service and tax information can affect the reliability of a pro forma.
Property taxes impact the calculation of net operating income, and the owner can't control the increase in taxes. Therefore, depending on the time horizon of the pro forma period, increasing property taxes can affect the bottom line. Similarly, in some cases, debt expenses may change the outlook. For example, if the mortgage has an adjustable interest rate, current costs could fluctuate significantly in the future.
What is the best use of a pro forma statement?
Investors should examine the seller’s or sponsor’s pro forma and evaluate its value. A reliable pro forma can help calculate potential net operating income, the IRR (internal rate of return), and the cash on cash return for a property.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
Programs that depend on tenants for their revenue may suffer adverse consequences because of any financial difficulties, bankruptcy or insolvency of their tenants.
